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Inflation: the road back to 2%

Chief Economist Paul Conway will deliver a speech on inflation.

Past Event
Wednesday, 19 June 2024 to Wednesday, 19 June 2024
9:00 am - 10:00 am

About the speech

The speech will draw on RBNZ research from 4 Analytical Notes which will be published at the same time.

These insights revolve around:

  • where inflation is being generated within the CPI basket currently (domestically generated inflation, especially services), 
  • what is driving this inflation pressure (more supply-side driven, especially via labour), 
  • how strongly and how this pressure is translating into headline inflation
  • what will drive inflation down in future. 

Note: There will be no update on the state of the economy since the May Monetary Policy Statement.

Watch a recording of the speech

Audio

Good morning. Kia ora koutou katoa. Thanks for joining us on this live webinar coming at you from at Te Pūtea Matua, the Reserve Bank in Wellington. So yeah, welcome, great to, thanks for clicking in. We're sort of looking forward to it. So the speech that I'm about to deliver is being published on our website currently at the moment. It should be there now hopefully. And you can actually, there's quite a few figures in this speech. It's sort of a bit of a presentation as well. So you can follow along in the speech on the website or there'll be flicking across the screen as well. I'm going give the speech slash presentation that'll take, I dunno, 25 minutes or so depending on how much ad-libbing I do. And then we are going to have a Q and A session for a bit. So there'll be a chat box on your screen so as we're going through, just put questions in there and then we will get to as many of those as we can after the speech.

Now there are two reasons why we're doing this. First of all, when I was lucky enough to get this job a couple of years ago, I said that we are going to talk more. So this is us talking more. The other thing is that we are publishing a heap of research alongside this speech and the speech effectively pulls together a lot of that research into a narrative. So we using research to, we're pulling research into the policy space, into the monetary policy space, which of course makes that research very useful and it strengthens where we're at from a monetary policy perspective. Alright, so let's get going. So yeah, as I said, thank you for tuning in. Great to have you with US inflation. It's been at the forefront of national and global discussions and concerns since partway through the COVID-19 pandemic. So coming out of the worst of the pandemic inflation in New Zealand and in most other countries was or reached rates that have not been seen or had not been seen since the inflation targeting era began more than a generation ago.

So annual consumer price index inflation, that's CPI inflation in New Zealand, it has moderated significantly over the past year or so. So we are making good progress but it remains above both pre pandemic levels and also the monetary policy committee, the MPCs one to 3% target range. So looking ahead we face some remaining challenges and uncertainties in bringing inflation sustainably back to target. So today I'm going to talk about why inflation dynamics changed in the New Zealand economy during the pandemic and what the road back to 2% inflation looks like from here. This is going to include a discussion on some of the risks and uncertainties that the MPC needs to balance as we navigate back to 2% inflation. Now just upfront the key insights for monetary policy from a monetary policy perspective, I've got two of them. First of all, there are some reasons to think that inflation may be more persistent than in our current projections in the near term.

So in other words, more sticky down to the downside and most notably domestic or non tradables inflation. And we're going to be talking about that a lot and services sector inflation have held up more than initially projected. However, there are also some reasons to think that inflation could fall more quickly than expected over the medium term. So for example, increasing spare capacity in the economy and product and labour markets could translate into lower inflation more quickly than currently expected. Also, business and household inflation expectations could hasten the decline as actual inflation falls continues to fall. So currently our policy strategy is balancing these opposing factors and as we noted in the May Monetary Policy Statement, monetary policy needs to remain restrictive to ensure that inflation returns to target within a reasonable timeframe and stays there notwithstanding future shocks, et cetera, et cetera. As always, we will be watching indicators of core inflation, non tradables inflation services, inflation and inflation expectations to get a read on how the balance of these factors is playing out going forward.

And of course the labour market is also providing really important signals on capacity pressures in the economy. So in this speech we are going to delve into recent reserve bank research and analysis on these factors. But first I want to set up that discussion by outlining several different components of inflation and how they matter from the perspective of our medium term flexible inflation targeting framework. And then I'll talk about inflation dynamics and their drivers over recent years and then we'll finish up with a discussion on what it all means for monetary policy overcoming quarters as we continue to bring inflation back to target. Alright, so first some words on medium term inflation. So MPC our remit requires us to keep annual headline or overall consumer price index CPI inflation between one and 3% with a focus on the 2% target midpoint and we're to do that over the medium term and we're also to do that while seeking to avoid instability in the economy.

Now to achieve this NPC sets monetary policy usually via the official cash rate or the OCR such that inflation is expected to return to target over the medium term and in most instances NPC we aim to return inflation to target to the midpoint of the target within a one to three year horizon. That's the medium term. Now this approach recognises that changes in the official cash rate take time to transmit, to percolate through the economy and influence inflation and also by ignoring or as we say looking through short-term price changes. This approach also ensures that the monetary policy committee does not cause unnecessary economic volatility by changing interest rates in response to inflation blips that would fade naturally in time in any case. So it follows that a really key consideration in setting the OCR is whether inflation pressures today are likely to linger into the medium term future.

Visual

Core inflation gives a steer on persistent inflation. Graph showing headline and core inflation from 2008 to 2023.

Audio

Now one of the ways in which we assess this is by using various measures of core inflation and you can see one of those measures on figure one here. So the sort of pink or raspberry or maro line there is one of our measures of core inflation, whereas the blue line is headline inflation. So you can see in the early days of the pandemic, oops, that headline inflation increased much more quickly than core inflation and I'll talk about that in a minute and you can see also that core inflation is now falling below headline inflation and I'll talk about that later on in this speech. So these measures, they help us identify persistent inflation pressures in the economy essentially by stripping out volatile price movements from the CPI. Now there's another useful gauge of medium term inflation pressures and that is non tradables inflation. So non tradable goods and services they tend not to be traded as it says on the tin not to be traded in global markets or exposed to global competition.

And they're really important. They make up about 60% of New Zealand CPI basket. Now non tradables inflation it tends to reflect capacity pressures and price and wage setting behaviours in the domestic economy very much linked to domestic economic conditions. In contrast, tradables tradable goods and services, they are traded internationally and tradables inflation as a result largely reflects changes in international prices that are driven by global developments and of course movements in the exchange rate.

Visual

Core non-tradables inflation broadly move together. Graph showing inflation subgroups versus core inflation.

Audio

Now in practise our two measures of medium term inflation core and non tradable inflation, they broadly move together and you can see that in this chart here. So the sort of purple and raspberry lines, they're not on top of each other but they broadly move together. Whereas tradables inflation, that's the blue line there, it's more idiosyncratic and it's more volatile quarter on quarter. So the factors that are influencing tradables inflation such as the exchange rate and global commodity prices, especially for oil or petrol, they're relatively volatile, they bounce around quarter on quarter whereas the factors influencing non tradables inflation such as wage dynamics in the domestic, the New Zealand labour market, they're less volatile and they can be relatively sticky.

Now of course core inflation includes prices for some tradable goods and services, but any short term volatility in those prices is largely stripped out in the measurement of core. So it follows that core and non tradables inflation are measures of medium term inflation pressures in the economy and therefore they're absolutely key in the conduct of monetary policy. Alright, with that sort of as background, let's turn to the inflation surge over the last few years. What's the big picture around that? So looking at recent history inflation in ERO in New Zealand, it breached the upper 3% limit of our annual CPI inflation target in the second quarter of 2021. And from there it rose to a peak of 7.3% a year later, second quarter of 2022. Now initially this inflation surge was driven by rapid increases in tradables inflation and again you can see this in the graph here.

Visual

Tradables inflation down, non-tradables persists. Graph showing inflation subgroups versus core inflation. Annual deviation from average since 2000.

Audio

So the blue bars are non tradables, the raspberry bars are tradable. So you can see tradables inflation really surged away in the early quarters of the pandemic. So much of this initial increase was driven by short-term factors, meaning that the increase in headline CPI inflation was not reflected in higher core inflation. I showed you that back on figure one. Headline inflation increase much more quickly than core inflation. Headline increased well above core inflation during the initial inflation surge. Now over late 2021 and into early 2022, inflation became more generalised and more persistent as cost pressures spread throughout the economy and workers and businesses started to expect higher inflation in future.

Visual

Non-tradables inflation has broadened. Graph showing contributions to non-tradables inflation by category.

Audio

So as a result both core inflation and non tradables inflation increased over this time. Now much of this initial increase in non tradables inflation was due to price increases for housing related services. So again, you can see that on this graph the green bars there are increases in inflation for housing related services.

You can see that was sort of the first to get out of the box. So why did that happen? Well most of us were spending more time at home because of the pandemic interest rates were low and fiscal policy was expansionary. So as a result, demand for housing related services increased but we didn't have an equivalent increase in the supply of workers, we didn't have an increase in construction materials, the supply of construction materials. So in that context increased demand translated into strong price increases for these housing related products. Now from the September quarter into 2023, housing related inflation began to fall partly because of increasingly restrictive interest rates. But as I mentioned earlier, excess demand and rising costs became a wider theme in the economy and high inflation broadened into prices for other non tradable items. And this included things like market services, restaurant meals, ready to eat, food administered goods and services such as alcohol and tobacco because of excise or partly because of excise tax and council rates, the kind of stubborn bits of inflation that we've been talking a bit over recent quarters.

Now more recently non tradables inflation, it has persisted and I'm going to say more on that in a minute. But those volatile short-term price pressures have faded and tradables inflation has quickly declined. So as a result, headline inflation has now or is in the process of falling below core inflation as we saw on that earlier chart. Alright, so let's dig a little bit deeper into this inflation surge. So to better understand the inflation surge reserve bank researchers have been exploring some of the deeper potential causes to these inflation dynamics. And let's start with reserve bank work looking into the role of supply and demand and influencing inflation pressures in the economy. So a study being released alongside the speech finds that retail prices, they actually fell at the start of the pandemic with demand slowing as people went into the first lockdown. And you can see that in this figure here that sort of the red bars are demand shocks and the blue bars are supply shocks.

So demand sort of fell in the early days but then that demand shock, it turned positive and it put significant upward pressure on retail price inflation from mid 2021.

Visual

Supply shocks a more important influence recently. Decomposition of headline retail trade deflator.

Audio

Now this increase in demand partly reflected covid era fiscal and monetary policy stimulus. So the effects of monetary policy over this period, we've been researching that obviously and they have been canvassed in a recent review which you can see on our website. I will say that I think people will be studying this period for decades if not generations to come economists that is. And I will also say that there has been less analysis of the full range of macroeconomic effects from fiscal policy over the pandemic. I think however it's important to say that the size of New Zealand's discretionary fiscal response, it was at the upper end across OECD economies. Now from 2022 the impact of demand shocks in driving retail prices began to wane as you saw on that earlier graph.

However, as some pandemic health related restrictions started to ease from late 2021, the composition of aggregate demand swung from goods, things that could be delivered while we were in lockdown to services, things we hadn't done for a while, like going out for dinner or going on a little holiday. And this occurred in the context of widespread disruptions and shortages on the supply side of the economy. So supply shocks became much more important in influencing inflation as we got through the pandemic. Alright, so that's one sort of approach to decomposing what happened over that time. Looking through a different lens gives us a similar story. So another study, another analytical note being published with the speech. It assesses some of the direct and indirect factors influencing wage and price inflation over recent years. And this work it suggests or it tells us that the labour market played a key role in New Zealand's inflation experience over the pandemic and actually a bigger role than seen in other countries to the extent that we've got comparable data for other countries.

So as aggregate demand began increasing from sort of mid 2021, labour demand started to increase. Make sense? We call that EM'S law but at the same time the border was closed so immigration inflows were at a virtual standstill which severely constricted labour supply in our economy. Now this tightening in labour market capacity pressures according to this research was the most important factor driving up wages over the pandemic and you can see that in this chart here, which decomposes wage inflation over the pandemic. The green line there is the contribution of a tight labour market and you see it was pretty powerful in the early days of the pandemic.

Visual

Labour market tightness key to wage inflation. Decomposing annual LCI wage inflation during the pandemic era.

Audio

Later on labour market the border opened and labour market pressures began to ease contributing to much less wage inflation and also tighter monetary policy by this point was also helping to limit inflation. Now in the product market this work suggests that the largest contribution to CPI inflation over the pandemic came from labour market tightness and supply shortages.

Visual

Labour market tightness, supply shortages key to CPI inflation. Decomposing annual CPI inflation during the pandemic era.

Audio

So you can see that in this graph the green and the sort of brown bars show you the contribution of tightness in the labour market and supply shortages to inflation over this period. And again, that large contribution from the tightness in the labour market likely reflects the ongoing impact of the closed border on labour supply and the persistent effects of global and domestic supply chain disruptions in combination with robust demand in the economy at the time. You can also see from the graph that increasing food prices have also been relatively persistent. That's the kind of purple line there and that is partly reflecting the impact of cyclone Gabrielle. But in contrast, the impact of energy prices on inflation in New Zealand has been relatively mild. So we weren't anywhere near as affected by the spike in global energy prices from the aggression in Ukraine that was relatively small here, just given that we were so far away from that shock as opposed to economies in Europe and the UK where energy price inflation played a huge role.

Visual

Labour market tightness a larger factor here. Factors influencing inflation across countries over the pandemic era. Factors include, energy prices, food prices, labour makrket tightness, supply shortages, productivity.

Audio

Now compared to other countries, to the extent we've got comparable data, labour market tightness bought about by the closed border and strong domestic demand had a big impact on inflation in New Zealand, which is not surprising. So migration plays a large role in growing the labour force here compared to other countries and also structurally the New Zealand economy, we are more labour intensive or capital shallow compared to many other countries and that would've also amplified the inflationary effects of that border being closed. Alright, so we are to from here now as we discussed in detail in our main monetary policy statement, we expect that domestic or the non tradables contribution to annual headline CPI inflation will continue gradually easing over coming quarters and this is going to set the stage for headline inflation to return to within the target by the end of the year. Alright, there are two sort of important contributions to this decline, sorry, there are two important contributions to this expected slowdown in non tradables inflation.

First of all, we expect spare capacity to start emerging in the economy over 2024. And this is after several years of the economy growing well beyond its sustainable rate. So demand has been greater than supply over the last few years. We're now entering a period where demand is beneath the potential growth beneath supply in the New Zealand economy. So capacity pressures are easing capacity, spare capacity is opening up in the economy and we expect the spare capacity to feed through strongly into lower domestically generated non tradables inflation. Now of course this expectation is supported by heaps of research including one of the papers or one of the notes we put out with this speech.

Visual

Effect of capacity pressure on inflation stronger than pre-COVID. Relationship between inflation and capacity pressure.

Audio

So another study being published with the speech finds that the effect of capacity pressures on inflation and for the economists out there, this is what we call the Phillips curve, we find that relationship between capacity pressures and inflation has become stronger over recent years.

And you can see this in figure nine here. So this kind of purple raspberry line is the link between capacity pressures and inflation and you can see it has clearly increased over the pandemic. So capacity pressures are having a bigger impact on inflation now than they were prior to the pandemic. So this strengthening in the Phillips curve relationship, it indicates that excess demand for goods and services and for workers in the labour market from partway through the pandemic was strongly reflected in higher inflation as we saw earlier. But it also suggests that remaining inflation could decrease quickly as spare capacity emerges in product and labour markets over 2024 I will say there's been a bit of talk of stagflation, I've seen a few headlines to that extent over the last couple of weeks. New Zealand we're not in a stagflationary environment like yes we are in a slow to no to negative growth environment but that the outlook for growth is slightly more positive going forward and the outlook for inflation is for declines to continue.

So that's the Phillips curve doing its thing, it's as anticipated and as required to get inflation back down to 2%. It is not stagflation. Now the second reason why we're confident about inflation falling is because we expect households and firms to increasingly build lower inflation expectations into their wage and price setting decisions, inflation expectations, they can become self-fulfilling. So lower inflation expectations will help reduce inflation. Persistence in the economy, and again we've done some research in this and it finds that above target in inflation over recent years, it prompted people to pay more attention to recent inflation and to update their inflation expectations more frequently. Inflation's been everywhere in the news obviously in the supermarket, so we're very focused on it and as high inflation expectations become more widespread, workers are more likely to bargain hard for wage increases. It's also really important to note that high actual and expected inflation, it also makes it easier for businesses to increase their prices.

So Reserve Bank research finds that businesses in New Zealand are more likely to increase their prices by more and more frequently when inflation is high. So when's the best time for a business to put up its prices when everybody else is putting up its prices? So these behaviours reinforced upward momentum in headline CPI inflation over recent years. But the opposite could occur as headline inflation continues to fall and recent falls in inflation expectations are very welcome in this regard and will help to embed lower inflation persistence going forward, moving from a period of high inflation back to a period of low inflation. So it's becoming increasingly difficult for businesses to increase prices in that new lower inflationary environment. Visual: Drops in inflation expectations will help embed lower inflation persistence. Graph showing inflation expectations and headline CPI.

Price increases are being noticed by consumers and of course if a business thinks inflation is going to be high in future, the temptation there is to sort of increase your price by a little bit more to try and get ahead of the curve.

But those days are, well they're almost behind us. Alright, so how is this going to play out in the inflation data? As I mentioned at the start, non tradables and core inflation will give us a steer on how quickly medium term inflation pressures are moderating in the economy to date declines in non tradables inflation. They have been concentrated in products that are sensitive to changes in monetary policy and again, we've done some work on this, we've split non tradables into three categories that respond quickly or medium term response or a slower response to monetary policy. And you can see that on the graph here. So the raspberry line there is faster responding products. You can see that that category of non tradables inflation for those products increased quickly at the onset of the pandemic but also what went up quick has come down quickly.

Visual

Non tradables inflation down via monetary policy sensitive prices to date. Graph showing non tradables inflation and monetary policy sensitivity.

Audio

So inflation in that category is now almost back at pre pandemic levels, which is great, but we anticipate that disinflation is going to spread across a wider set of nont tradables that typically take longer to react to monetary policy.

And this is things like restaurant meals, ready to eat food, et cetera, et cetera. And again, you can see from the chart this is the medium response there. Its products in that category of non tradables inflation in this category of non tradables increased relatively slowly over the pandemic and has only recently started to decline and this decline is likely to continue particularly as conditions in the labour market continue to ease. So many of the products in this category are labour intensive and therefore particularly sensitive to what's going on to pressures in the labour market. Now importantly there are some non tradables that respond only slowly if at all to changes in monetary policy. And again, you can see that in the graph that's the purple line there. For example, inflation in some administered goods prices is going to fall with a delay. Excise tax for example is indexed to CPI.

So high inflation sort of gets baked in to prices for products that are subject to that tax prices for other non tradables in this category such as insurance have been slow to respond or they haven't responded to restrictive interest rates and the pace of increases in prices for these products may only start to wane after other factors that are driving them upwards such as pandemic and weather related disruptions have fully run their course. Monetary policy is having a small to zero influence on prices for those products compared to those other forces driving them in the economy. But those other factors will run their course. There's no such thing as a price that just keeps going up forever and ever. So overall we expect to see slowing inflation spread out across a greater share of non tradable products and the extent of large price increases across the CPI to return to its pre covid average.

Visual

Slowing inflation needs to become more broad-based. Graph showing distribution of CPI price changes.

Audio

So you can see from this graph here that 40% of items in the CPI basket, this is in the first quarter of 2024, 40% of those items went up by more than 5% in the first three months of this year. Over 70% of items in the CPI basket went up by more than 3% in the first quarter of this year. So we expect to see large price increases like that return to where it was pre covid. Pre covid it was under 10% for the share of CPI items going up more than 5%. Alright, so in conclusion, inflation spiked higher during the pandemic due to a range of factors with a shortage of labour and materials in a period of strong demand being particularly important, broad-based non tradables inflation has been key to driving medium term inflation pressures. Now good progress is being made in bringing inflation back to target, but increasing spare capacity in the economy is likely to further reduce inflation pressures going forward and a further easing in the labour market will be a key part of this process.

Lower inflation expectations and a lower propensity for firms to make relatively large price increases will also help lower inflation persistence going forward. And these processes, they could occur more quickly and more slowly than we are currently projecting. The risk of ongoing strength and non tradables inflation is balanced by the potential for a quicker moderation in inflation expectations and increasing spare capacity in the economy passes through to weaker demand and weaker prices overall, a period of restrictive policy is necessary to give us confidence that inflation will sustainably return to target over a reasonable timeframe. Thank you for that. That's it as far as the set piece go, we're going to shift to Q and A. So we've got James here who's been moderating questions, hopefully questions that have been coming in and is going to throw some at me now.

James

Right. Thanks Paul. We've got a lot of questions so we will try and get through as many as we can. Have the papers released today changed your understanding for how inflation is likely to evolve going forward? If so, in which direction?

Paul

That's a good question. Em research, you have your priors, you have an understanding of how the economy works and one piece of research, yeah, it'll update priors around that aspect of how the economy works. I don't think it's a radical change, I think it's more an evolution in view based on research rather than a fundamental kind of shift. I think for example, the Phillips Curve paper, it gives us increasing confidence that what we are doing with the economy and definitely in a slow patch that is going to work, that is going to bring down inflation and we sort of knew that was the case. The Phillips curve is well established, it's sort of a mainstay of contemporary macroeconomics discovered by a New Zealander economist Peter Phillips by the way. So the researcher sort of gives us confidence in our framework and at the margin it will change our view here or there. I'm not sure I understand what you mean by in which way, depends on what aspect we're talking about.

James

The next question is from SGK. Paul, given that growth has been negative for four of the last five quarters, unemployment is rising, thousands of young New Zealanders are leaving for Australia and you are forecasting inflation back inside the target banned by year end. Isn't the level of restrictive policy now doing real damage to the New Zealand economy?

Paul

Thanks SGK. Our job is to get inflation back to the midpoint or back to the target with a focus on the midpoint. And yes, we are definitely in a period where that is causing that mission is causing the economy to grow more slowly than it otherwise would, but so we are experiencing some short run pain. The idea there is that the gain of low and stable inflation is going to be worth it. In terms of New Zealand is leaving for Australia, I do think there's still a bit of pent up desire for OE overseas experience there and the extent to which people are fleeing or are sort of trying to move to a better performing economy. And I note recent media saying is the grass really greener in Australia? But the extent to which the New Zealand economy is not doing as good a job as it possibly could of increasing wellbeing of New Zealanders, you have to be really clear on what the role of monetary policy is or is not in that. So monetary policy, it's very much about the business cycle.

We try to sort of mitigate the business cycle so that we keep inflation low and stable. That sort of structural growth in the New Zealand economy, the sort of linked to monetary policy there is that low and stable inflation over the long run is the best contribution that we can make. But yes, absolutely policies that would increase productivity, that would increase average incomes over the medium to long term In New Zealand that's more where you need to look for those sort of long run structural factors. New Zealand's productivity growth is not as high as it is elsewhere and I think at the margin that can be a magnet for young kiwis looking to improve economic outcomes for their whanau but think hard before jumping.

James

Next question is from David Tripe. To what extent can some of the domestic sources of inflation be attributed to responses to climate change insurance and local body rates to some extent and switches of supply of services from central government to local government. Would this justify ignoring these for monetary policy assessment?

Paul

Yeah, so climate change, obviously cyclone Gabrielle and we talked about this in the speech, it did put a sort of upward pulse through food prices and that is part of the reason why inflation has been higher than it otherwise would over recent years. And I think climate change off the back of that climate event insurance premiums have been going up and that's common after the Christchurch earthquake insurance premiums went up. So this sort of an increased realisation of the risks of life in New Zealand, the shaky isles and also of the impact of climate change whether cyclones are going to be an ongoing feature. So that's sort of the underlying or the more structural drivers of things like insurance premiums and I said they're sort of less sensitive to changes in monetary policy and the extent to which that is a relative price shift. It's just something that needs to happen because we've sort of had this realisation about risk to the extent that it's a relative price shift, then absolutely monetary policy, we do look through that.

That only becomes an issue for monetary policy if it feeds into higher cost structures and higher inflation and higher inflation expectations more generally throughout the economy, that's when monetary policy needs to lean against that. The other point I'll make David with this question is that even if you strip out things like rates and insurance, et cetera, et cetera, inflation pressures are still widespread across the New Zealand economy. Yes we are making good progress. It's nowhere near as bad as it was a couple of years ago, but that figure showing that 40% of CPI items went up by 4% by, sorry more than 5% at the first quarter of this year. It shows that inflation pressures are broader than just those non tradables that are extremely impervious. It would seem to monetary policy. So there's still a job to pull that down and I will acknowledge the economy is changing rapidly at the moment. That's Q1 inflation data, really looking forward to Q2 inflation data but we don't get it for a good few weeks. Be good if we had monthly inflation data.

James

Thanks Paul. Next one is from John Smith. Do households have the time RBNZ needs to lower housing inflation? We are heading for six quarters in a row with low growth. Don't you think it's particularly dangerous to make short-term monetary policy adjustments looking at revisions of longer term parameters such as potential GDP?

Paul

I'm not sure I understand that question. I don't get the bit about do households have time? Can you just repeat that James that sentence? Yeah.

James

Do households have the time RBNZ needs to lower housing inflation?

Paul

Alright, I think you're sort of talking about households are getting stressed with higher interest rates and you're wondering if they can hang in there until inflation does sustainably go back to target? Yes, is the answer to that. When you look at, I fully acknowledge that the New Zealand economy is in a slow to no to negative growth phase. As someone said four out of the last 5G DP quarters have been negative. We get an update on that tomorrow. So yeah, it's challenging, but again we have confidence that that is going to get inflation sustainably down. When you look at measures of financial stress, yes they are increasing but they're still relatively low. So we don't see financial stability as meaning that we can't do the necessary with monetary policy. And what was the second bit of that question?

James

It was asking about the dangers of making short-term monetary policy adjustments looking at revisions of long-term parameters such as potential GDP

Paul

Potentially, but I think you might be referring there to the fact that in our main Monetary Policy Statement, we revised down our projections for productivity growth in the New Zealand economy. Basically based on recent data. New Zealand's productivity performance recently has been even worse than normal. So that meant we reduced our potential output growth in the New Zealand economy. That's not a huge shift in our projections at the margin. It means capacity pressures are a bit higher than what we thought they were, but it's not, I don't think we are making short-term monetary policy decisions based on changes to long run parameters such as potential output. I mean it's better than the alternative of not sort of revising your view on these long run parameters. We have to do that as we learn more about how the economy operates. It would be remiss of us, negligent of us not to sort of be constantly updating our models. But yeah, I fully take your point and I sort of push back, I don't think we are making monetary policy decisions. It's about tradables inflation, core inflation, everything I've talked about in the speech, everything we talk about in the NPS and at the margin we've had that reduction in productivity growth projection.

James

Next question is from curious George, if Bryce is in love your work,

Paul

George, my boy used to love your stuff.

James

If rises in insurance premiums and property rates which are relatively price and elastic keep inflation above 2%, will you require other prices to deflate to compensate or will you accept an inflation rate of say 2.3 to 2.5 following this? At what point will concern over rising unemployment and no growth outweigh the benefit of getting inflation to two from say 2.5?

Paul

Yeah, thanks George. You are curious indeed like inflation and rates to the extent as I was talking about earlier, to the extent that they are relative price shocks or shifts, then yes, we will look through them and we would tolerate inflation being at 2.2 or 2.3% as a result of those relative price shifts. But relative price shifts, they don't go on forever, they just do their thing and then generalised inflation pressures will fall back to our target midpoint if inflation expectations are well anchored. So the beauty or one of the beauties of our flexible medium term inflation framework is that it does allow us to accommodate those types of shocks, those types of relative price shifts. They're very front and centre at the moment because everybody's, well, we're all talking about it, but as I've said, it's generalised inflation pressures in the New Zealand economy that we're leaning back against.

So we're not holding the OCR at 5.5% because of those relative price shifts. We see inflation pressures as being more generalised across the economy and as people adjust their expectations as persistence and inflation decreases, or let me put it another way, the sooner people start to base their economic decisions and behaviours on a low inflationary environment, which is what we're moving into, then the sooner those generalised inflation pressures in the economy decline and the sooner interest rates or the OCR at least starts to fall. We're in a really interesting moment currently where what we call the output gap. So it's capacity pressures in the economy is broadly balanced. We think the labour market is sort of somewhere around maximum sustainable employment. So it's why do we need spare capacity to emerge in the economy? And the answer to that is we essentially need to do that to sort of ring those generalised inflation pressures out of the system.

And part of that process is people adjusting their inflation expectations downwards. So workers in terms of wage demands, wage increases? Yes, absolutely as long as they're based on productivity improvements. And from a business perspective, I sort of said during the speech it has been a relatively easy time to increase prices because people don't notice in an inflationary environment, but we are moving out of that environment so businesses need to adjust to a new inflationary environment. And I talked about a lower propensity for businesses to make large price increases. That's the stuff we're pushing back against, not those relative price shifts.

James

The next question is from up the Waz Warriors fan, go the was Paul, do you think you can cut rates as soon as you get into the band or do you think you will need to see CPI print in the band a couple of times before you have the confidence that you can reduce the OCR?

Paul

Yeah, disappointing game on Saturday they started really strong and then Wilford, I thought they were going to sort of topple the top of the table but they didn't get there in the end. But anyway, we all know they can and hopefully they will In terms of when interest rates are going to start to fall, there's nothing sort of mechanistic about it. It's not a sort of when inflation equals this, then we can do that. We take a really broad read across the economy. Our monetary policy statements are really detailed. We look at everything to give us the confidence that inflation will be sustainably back in the band and we are just not there yet. But no, I can't sort of give you the magic formula for when interest rates are going to decline. All I can suggest is read the monetary policy statement, they're excellent documents and it's all laid out there, what the path forward looks like and what that means for interest rates.

James

Next question is from Hamish Pepper. Given this research and recent data, have the balance of risks for your forecasts shifted at all? Does that have any implications for the MPCs reaction function or regrets analysis?

Paul

Yeah, as I said earlier, I think a lot of this, the analytical notes and our research function more generally, I'm just delighted we are really cranking out some research now. It's really helping the MPC get our heads around inflation dynamics. So yes, we are constantly updating our view based on research, based on the data. I'm not sort of going to talk about the balance of risks going forward because save that for the MPR coming up and more so for the August MPS side. I don't want to get ahead of that process. I can't really talk on behalf of MPC when MPC hasn't done the mahi. So yeah, all of that's coming up. Hamish,

James

A question from Jason. How much of an impact on inflation are sustained price increases in insurance and local body rates expected to have?

Paul

I don't have that number off the top of my head. I'm miss you Rebecca. She would know that but significant actually, Jason, I can get back to you on that. We can sort of get back to you on the impact of those relative price shifts on inflation. So yeah, hopefully we've got your email there.

James

Question from Ben. Did the research estimate the contribution of the rapid increase in house prices on inflation?

Paul

No, we have done research on that. That's the sort of, we talk about a wealth effect. So as house prices increase, and we saw this over the pandemic, one of the reasons that demand was strong over the pandemic was because the value of people's houses, or the price I should say of people's houses was going up for various reasons. That was actually my first speech at the reserve bank 18 months ago was all about what was happening in the housing market and that was based on a big tranche of research that came out with that speech as well. So I refer you back to that speech and that material to get a good handle on the impact of changes in house prices on inflation. I will say the housing market that's been going sideways lately. So those wealth effects, they're not pushing up inflation currently would be my assessment

James

Question from El surprise that the stop in tourism and international education during Covid wasn't mentioned. I would've thought that this would've reduced our exports, which would devalue the kiwi dollar and increased imported inflation.

Paul

Yeah, we talk about that a lot again in MPS and I think my last speech, I touched on tourism as well, so it came to a standstill over the pandemic when borders were closed and had a huge, there's a huge hole in New Zealand services exports over that period like goods exports of goods. They were pretty flat over covid but they didn't fall anywhere near as much as services export. So yeah, that did really reduce export performance. It's part of the reason why our current account deficit increased in terms of the exchange rate effect. You need to think about exchange rates as sort of what's going on here relative to what's going on everywhere else in the world. And one of the sort of defining features of the pandemic, that shock has been common across countries. So all countries have been going through broadly similar macro dynamics. We're starting to get a bit of divergence now as that covid shock sort of works its way through the system. But the New Zealand dollar exchange rate, it's bounced around a bit but it's been surprisingly stable over the last couple of years and I think a big part of that is because that shock has been common across country. So those kind of cross country relativities changing as much as what they did prior to Covid and what they're likely to do going forward as well.

James

Next question is from too high, too long, whatever happened to the road back to target range ie 1 to 3%, it seems your message is to sustainably achieve 2% now.

Paul

Yeah, that's just the legislation. Our target is 1 to 3% with a focus on 2% too high, too long. That sounds like a dodgy weekend.

James

A question from G, you've stated restrictive policy is necessary, but to what degree is the level important at this point in the cycle? Real rates continue to increase and will do so for the remainder of the year. Should rates not be adjusted lower to a level more commensurate for the balance of risks?

Paul

That's a long question. That's long.

James

I'll just give you the first part of that one.

Paul

Okay, there's more is there?

James

Yeah, right. Let's do the first bit first. Alright.

Paul:

Okay, again, sort of cutting to the issue of when an interest rate's going to fall. And again, I'm just going to sort of push back and say there is no simple answer. I think it's interesting as inflation comes down, is that equivalent to real rates going up and should nominal interest rates kind of follow inflation down, but then real rates, how are you measuring real rates? They should be based on expected inflation and over what time period are you measuring expected inflation current year or five year or 10 year. So there's many, again, there's not a simple sort of response to that question. Read the MPS and it's got a lot of detail in there in terms of what needs to happen for interest rates to fall.

James:

Part of part two and then we'll move on. Similarly, how much can you rely on your forecasts for read on spare capacity emerging in the labour market?

Paul:

Actually we put out an analytical note or a discussion, babe, I can't remember on this by Chris Ball not so long ago. Looking at a range of different indicators of labour market pressures. I can't remember how many there were. It was double digits anyway, like 15 or 20, something like that. And it's actually a standard graph in the monetary policy statement. We sort of put a heat map of where those various indicators of labour market tightness are relative to their sort of median. And what you find is a lot of them do tend to move together. They tend to be quite correlated. So I think on balance out of that work, out of our labour market indicator suite, I actually think we've got quite a reasonable read on what's going on in the labour market. So I actually feel pretty confident that we've got a good read on the labour market.

I do think the New Zealand economy is not measured particularly well. My last speech was about the importance of good data. So I take your point that sometimes it can be difficult to tell what's going on in the New Zealand economy because our data gets revised quite a bit and can sort of come out with a lag. We sort of try and make up for that by looking at other sort of alternative sources of data. So there's always going to be room for improvement. Absolutely. But I do, my sense is that we've got a reasonably good understanding of what is going on in the labour market. So I do feel confident that that is giving us a reasonable read in terms of what should be happening with inflation going forward and interest rates.

James:

Next question is from Natalie. How much weight should we be putting on non tradable inflation compared to tradable when setting the OCR?

Paul

Yeah, thanks Natalie. In terms of our remit, it's about headline or overall CPI inflation. But because we're always looking ahead, what we do with monetary policy today affects inflation 18 months to two years into the future. So when you're projecting annual headline, CPI inflation, all of that short run volatility, it sort of drops out of it. So headline and core inflation become quite close to each other and we saw in one of the graphs that core and non tradables inflation also, they tend to sort of broadly move in a similar way. So those indicators of medium term inflation pressures are very important in terms of the conduct of monetary policy, which is not to say we just disregard high frequency volatility in inflation. We've been talking a lot about drivers of high frequency volatility in inflation and it's not as if we ignore tradables inflation. All of that is really important context, but it's really those medium term inflation pressures that set the scene at least or set the backdrop for what's going on with monetary policy. And that's partly or largely because we're a medium term inflation target as are many central banks. That's the best way of doing it.

James

But we're almost out of time, but I'll throw a couple of quick ones at you. Dave asks, does a higher OCR meaning higher interest rates actually influence CPI upwards where there are things like rent where things like rent are concerned, for example, landlords passing on higher costs?

Paul

No, no. Rents are going up strongly at the moment because our population has been growing at near 3% and we're not that great at building houses. So increased demand for rental accommodation is showing up as increases in price. This idea that higher interest rates increase inflation, Turkey sort of thought that for a long time and ended up with inflation around 80 or 90%. The Phillips curve work that we've been doing that I've spoke about that relationship between capacity pressures in the economy, which are influenced by interest rates and inflation, it's very well established and well-known globally that higher interest rates translate into lower inflation.

James

Next question is from Dan Brunskill with inflation mostly in select services. Should consumers expect to see stable prices for most goods on shop shelves today?

Paul

Yes, I think that's true. There is a lot of non tradables. I didn't really talk that much about the service sector inflation, but a lot of non, there's quite a bit of overlap there between non tradables and because by their nature it's challenging or it's tricky to trade services internationally. I think the technology is changing that and I actually think exporting services is a huge opportunity for New Zealand given our geographic economic geography being remote and all of that. But because there is that sort of overlap between services and non tradables, whereas goods tend to be more tradable globally. And we have seen tradables inflation come down to almost pre pandemic levels. So we are seeing a split. It's also coming out of the pandemic. Demand for services really surged. So it was about going out for dinner and there's a whole heap of market services in there. So yeah, we are seeing a bit of a dichotomy, the kind of remaining kind of holdouts in terms of inflation reduction. It is a non tradables and a fair chunk of that will be services. And I think we're seeing that. I think food price inflation came out not so long ago. It's a good as the lowest it's been for X years. I can't remember the number, but it was good. It was gratifying, reassuring.

James

And a quick follow up from Dan, when you begin to cut rates, how soon will the real economy experience that looser monetary policy?

Paul

We've got this thing again, it's well established that interest rates take about 18 months to two years to influence inflation. But the influence, there's quite a transmission sort of channel from interest rate changes to inflation. So if we change the OCR markets, react virtually instantaneously, and then interest rates get into those kind of wholesale interest rates, get into retail interest rates eventually. So then consumption and investment at the margin do increase off the back of that and then 18 months to two years later it gets into inflation. So that process takes time. Again, I don't have a sort of X quarters into the future. Growth will improve, but there's kind of a cascading series of events working through the real economy for interest rates to influence inflation. So less than 18 months to two years, I guess is the answer.

James

Paul, we're out of time. It's gone 10 o'clock. Wonderful. Over

Paul

To you. Okay, thank you everyone. I hope that was useful. Please do engage with the research. Tell us what you think, read the speech. Thanks very much for tuning in. I really enjoy talking to you like this. I think it's really sort of democratic and accessible, so cheers for that. Kia ora, everybody. And ka kite.

Speaking engagement: 5.30pm, 19 June

Chief Economist Paul Conway will join a panel discussion with the Bank of New Zealand and clients, at their Wellington headquarters. Mr Conway will refer to his speech delivered earlier in the day. There are no separate published notes for the panel discussion. 

More information

Download the speech (PDF, 1MB)

May Monetary Policy Statement

This speech follows on from speeches given at the start of 2024: 

The Monetary Policy Remit and 2% inflation
The importance of quality research and data

Media contact

James Weir
Senior Advisor, External Stakeholders
Mobile: 021 103 1622
Email: [email protected]